On the Uncertainty of China's Monetary Policy Transmission Mechanism

Author: Zhang Yong
Publisher:
Publish Date: 2006-11-01
Features: Since the State Council issued the "Decision on Financial System Reform" in 1993, establishing price stability as the primary monetary policy goal, China's national economic performance has experienced cycles of inflation, deflation, and inflation again, with highly unstable price fluctuations. This may indicate that the People's Bank of China (PBOC) has not effectively achieved the price stability goal. In light of this, studying the price-oriented transmission mechanism in China after 1994 and exploring its uncertainties holds significant practical implications. This research topic argues that the uncertainty in the monetary policy transmission mechanism may stem from various factors impacting the PBOC's use of policy tools to achieve price stability, making it difficult to achieve the target. This book first interprets the uncertainty in China's monetary policy transmission mechanism from a modern monetary theory perspective as the uncertainty in the PBOC's process of achieving price stability goal under two operational frameworks: the AD-AS model based on the monetary model and the Phillips curve model. On this basis, it further analyzes: (1) the inherent uncertainties in each operational framework, including the nature, mechanisms, effects of shocks at each stage of the transmission, and corresponding operational strategies; (2) the uncertainties in choosing operational frameworks, based on the PBOC's experience in selecting operational frameworks from market-oriented countries in the West, proposing possible solutions for China's future operational framework selection and improvements to the existing framework.
Since 1993, when the State Council issued the "Decision on Financial System Reform," establishing "maintaining monetary stability and promoting economic growth" as China's monetary policy goal, price stability has become the primary objective of China's monetary policy. Meanwhile, the People's Bank of China has continuously improved its indirect control mechanism for monetary policy, gradually establishing an operational framework where open market operations serve as the routine policy tool, excess reserves as the primary operational target, and money supply as the intermediary target, attempting to achieve price stability through policy operations. However, since then, China's national economic performance has experienced cycles of inflation, deflation, and inflation again, with highly unstable price fluctuations, suggesting that the PBOC's implemented monetary policy has not effectively achieved the price stability goal. In response, we argue that the uncertainty in China's monetary policy transmission mechanism may have hindered the achievement of the price stability goal. Specifically: during the transition of China's economic system to a market economy, various factors have impacted the PBOC's process of using policy tools to achieve price stability, making the monetary policy transmission mechanism uncertain. In this context, if the PBOC fails to adopt appropriate operational strategies and frameworks to control these shocks and reduce uncertainty, it may struggle to achieve the price stability goal.
So, how should we understand the current uncertainty in China's monetary policy transmission mechanism? What operational strategies and frameworks should be adopted in practice? These are the starting points of this book's research. Western economists' research on the uncertainty in the monetary policy transmission mechanism can be summarized as follows: first, the monetary policy transmission mechanism under the impact of shocks is treated as an economic phenomenon. Then, theoretical models of the monetary model and the Phillips curve model of the monetary policy transmission mechanism are proposed, and corresponding operational frameworks are established based on these models, interpreting the uncertainty in the monetary policy transmission mechanism as the PBOC's process of achieving price stability goal under two operational frameworks using open market operations as the primary policy tool. On this basis, it specifically analyzes: (1) the inherent uncertainties in each operational framework, including the nature, mechanisms, effects of shocks at each stage of the transmission, and corresponding operational strategies; (2) the uncertainties in choosing between two operational frameworks, where the PBOC, as the implementer of monetary policy, should select one of the two operational frameworks as the basis for its operational practices.
The author believes that as China's monetary policy control mechanism shifts from direct to indirect control, examining the uncertainty in China's monetary policy transmission mechanism after 1994 can follow the above approach. However, since China's interest rate liberalization is relatively low, a complete operational framework based on the Phillips curve model is not suitable for understanding China's monetary policy transmission mechanism, but the AD-AS model remains applicable. Therefore, we can interpret the uncertainty in China's monetary policy transmission mechanism as the PBOC's process of achieving price stability goal under two operational frameworks of the AD-AS model based on the monetary model and the Phillips curve model. On this basis, this book primarily analyzes: (1) the inherent uncertainties in each operational framework, including the nature, mechanisms, effects of shocks at each stage of the transmission, and corresponding operational strategies; (2) the uncertainties in choosing between operational frameworks due to the constraints of interest rate liberalization, where China's current operational framework does not yet involve a choice between the monetary model and the Phillips curve model. However, as interest rate liberalization continues to improve, when conditions are ripe for adopting a framework based on the Phillips curve model, the same operational framework selection issues may arise. Meanwhile, the existing operational framework based on the monetary model still has room for improvement. Based on the author's research on the experience of operational framework selection in market-oriented countries in the West, possible solutions are proposed.
Specifically: this book first proposes the uncertainty in the PBOC's process of achieving price stability goal under two operational frameworks of the AD-AS model based on the monetary model and the Phillips curve model. For the uncertainty in achieving price stability goal under the monetary model framework, it includes: (1) when the PBOC uses open market operations to regulate reserve positions in the reserve market to achieve a total reserve target (or a primary target of excess reserves), various shocks make its control of the operational target uncertain; (2) when the PBOC regulates the total reserve target to achieve a money supply target, the process of achieving the money supply target is uncertain if there are shocks affecting the PBOC's regulation of reserve levels and the asset portfolio behavior of banks and the public; (3) when there are shocks causing instability in the velocity of money income circulation, the process of achieving the nominal output target through regulating the money supply target becomes uncertain; (4) when nominal output is decomposed into real output and inflation rate, there is a problem of weight allocation, making the process of achieving the inflation target uncertain. For the uncertainty in achieving price stability goal under the Phillips curve model framework, it includes: (1) when the PBOC uses policy operations to achieve real output and output gap targets, changes in inflation rate expectations make this transmission process uncertain; (2) when the output gap is determined by the inflation-output gap substitution relationship reflected by the Phillips curve, shocks that may destabilize this substitution relationship make the process of achieving the inflation target through the output gap uncertain.
Based on the above analysis, this book further explores the inherent uncertainties in each operational framework. Regarding the uncertainty in the monetary model framework: this book first examines the various shocks, mechanisms, effects, and the PBOC's response methods when regulating operational targets through open market operations, as well as the effectiveness of achieving operational targets. The study finds that the PBOC's operational target is to achieve consistency between excess reserve levels and market liquidity, classifying shocks into extrinsic factors unrelated to policy operations and intrinsic factors caused by policy operations themselves. Among extrinsic factors, the PBOC cannot offset the impact of changes in the statutory reserve requirement rate and banks' asset portfolio behavior, but it can offset other factors as long as they are accurately identified. Intrinsic factors arise from banks' expectations of policy operations differing from the PBOC's intentions, leading to significant fluctuations in short-term interest rates in the reserve market. The PBOC can eliminate the impact of these shocks by guiding banks' expectations and reducing their expectation errors. Second, this book analyzes the various shocks, mechanisms, effects, and corresponding operational strategies when the PBOC regulates the total reserve to achieve a money supply target. Here, shocks are also divided into extrinsic factors unrelated to policy operations and intrinsic factors caused by policy operations themselves. For extrinsic factors, the PBOC can offset them as long as it identifies them in time and responds according to certain rules. However, intrinsic factors refer to the impact on money supply caused by the PBOC's "offsetting" of extrinsic shocks while changing banks' expectations of policy shifts and their asset portfolio behavior. In this case, the PBOC should stabilize and guide banks' expectations to eliminate the impact of these shocks. Third, this book explores the shocks, mechanisms, effects, and corresponding operational strategies causing instability in the velocity of money income circulation. The study finds that such shocks mainly refer to fluctuations in financial market transactions (referring to stock market transactions) and changes in the public's credible expectation of the PBOC's ability to achieve economic stability. For financial market transaction shocks, the intrinsic mechanism by which the shock affects the velocity of money income circulation is the public's functional substitution behavior of money, leading to the substitution of corresponding functional monetary assets and total money. The substitution pattern of monetary assets and total money changes this impact effect. In fact, the substitution pattern of monetary assets and total money mainly depends on the functional meanings of existing monetary assets and total money, indicating that the PBOC should focus on analyzing the functional meanings of monetary assets and reasonably determine the statistical scope of each level of total money to clarify the substitution pattern. Changes in the public's credible expectation of the PBOC's ability to achieve economic stability will alter the assets they consider in their portfolio behavior in terms of risk and liquidity, leading to corresponding changes in their asset portfolio behavior and altering the variable relationships of money demand, thereby affecting the stability of the velocity of money income circulation. This requires the PBOC to ensure that the public's credible expectation of its ability to achieve economic stability remains stable. Regarding the uncertainty in the AD-AS model under the Phillips curve model framework: this book first examines the impact of the public's inflation rate expectations on this transmission process when the PBOC's policy operations affect real output and output gap. Using China's deflationary period from 1995 to 2002 as the research period, the book analyzes the mechanism, effects, and operational strategies of deflationary expectations on real output. The study finds that deflationary expectations have a strong contractionary effect on real output, expanding negative output gaps and intensifying deflation. In this context, the PBOC should create appropriate inflation expectations to reduce output gaps and alleviate deflation. Second, this book analyzes the shocks, mechanisms, effects, and operational strategies causing instability in China's Phillips curve. The shocks include: factors causing uncertainty in the responsiveness of inflation to output gaps, changes in labor productivity, and changes in the public's credible expectation of the PBOC's ability to achieve price stability, leading to uncertainty in the formation of inflation expectations. For the first two shocks, the PBOC can effectively control them through operational strategies, while for the public's credible expectation, the PBOC should establish a reputation for maintaining price stability to enhance the public's credible expectation.
Finally, based on the author's research on the experience of operational framework selection in market-oriented countries in the West, possible solutions are proposed for the future selection of operational frameworks in China under higher interest rate liberalization conditions and the improvement of existing operational frameworks. First, from the evolution of operational frameworks in Western countries from the monetary model to the Phillips curve model, China's future operational framework may also evolve similarly. Regarding the improvement of the current operational framework, the PBOC should, on one hand, adjust the target value of money supply as practicalist monetarists do based on new information, and on the other hand, consider other models and use certain indicators from operational frameworks based on these models as decision-making references. Second, from the experience of some countries shifting from the Phillips curve model to the inflation target model, we believe that whether China will evolve from the Phillips curve model to the inflation target model after adopting an operational framework based on the Phillips curve model depends on specific conditions. However, the inflation target model operational framework still offers lessons for improving China's existing operational framework, including enhancing the public's credible expectation, making commitments to price stability, and increasing policy transparency.